Intimidated By Your New 401k? Try a Target-Date Fund

by Alyssa Oursler | April 5, 2013 10:35 am

401ks are easy-to-use investment vehicles that come with a lot of perks, including the fact that they are tax-deferrable and many employers will match your contributions. Considering far too many recent graduates[1] either aren’t offered them or aren’t invested, if your company does offer a 401k plan, you best be signing up[2].

[3]Of course, starting is only the first step. Once that’s out of the way, you still have to look through your 401k’s offerings and decide how to allocate your contributions.

While that step might sound overwhelming, it doesn’t have to be. There are plenty of resources out there[4] that can help you get started, and there even are options within the 401k plan itself that take a lot of the decision-making off your hands.

One such example: target-date retirement funds.

Age & Risk

The driving factor behind your 401k allocations is risk. You don’t want to invest in two mutual funds that hold basically the same stocks, for example, because all your eggs are in one basket. Variety naturally defers risk.

But diversification within an asset class — like stocks — is only one piece of the puzzle. As we’ve talked about before[5], you also want to hold the right variety of assets, as some are less risky than others, and some assets tend to do well when others slump, helping hedge your bets.

Young investors have more time to grow their money and thus have more room to take risks — meaning they should hold more stocks, which are considered riskier assets. Older investors who are nearing retirement, on the other hand, should be more conservative. They are in “capital preservation” mode — focused more on keeping what gains they have rather than trying to aggressively pile up more — and thus should hold more fixed-income assets, such as bonds.

Of course, the decision isn’t a straight either/or. Instead, it’s more of a curve — often called a glide path — as you shift your allocations gradually over time.

A No-Stress Option

Trying to navigate that curve on your own isn’t impossible, but it’s not easy. However, if you opt to invest in a target-date fund, a fund manager will … well, manage it for you.

Think of it as a 401k plan on autopilot.

All you have to do is pick the fund with the year in its name closest to the year you hope to retire. For example, a 21-year-old planning to retire at age 65 would want to be in the Vanguard Target Retirement 2055 Fund (MUTF:VFFVX[6]). Whoever is running the fund picks stocks, bonds and sometimes other assets that have a level of risk appropriate for the number of years I have until retirement, adjusting the holdings accordingly as I go.

Since the retirement age for people in the VFFVX is about four decades away, it’s much more weighted in stocks at this point. Nearly 90% of its holdings are stocks — 60% of the fund is invested in U.S. equities, with another 25% in foreign stocks — and the remaining 10% is sunk into bonds.

Right now, Apple (NASDAQ:AAPL[7]), Exxon Mobil (NYSE:XOM[8]) and General Electric (NYSE:GE[9]) are some of the biggest names in the fund, with exposure to names like Samsung (PINK:SSNLF[10]), Nestle (PINK:NSRGY[11]) and Sanofi (NYSE:SNY[12]) also worked in.

That’s a far cry from, say, the Vanguard Target Retirement 2025 Fund (MUTF:VTTVX[13]). Its bond exposure is nearly three times as large — just over 29% — with U.S. and international equities making up the remaining 71%. That’s because investors in the VTTVX are only 12 years away from their target retirement, so importance has shifted more toward preserving the funds they’ve built up.

Words of Caution

As always, there’s the fine print to consider.

Many suggest that if you go this route, you should avoid investing in other funds because all your diversification is already built into the target-date fund. If you take that advice, you’re saying your retirement will be a wholly hands-off affair. (Granted, you can always switch your holdings down the road once you have a better grasp on what’s going on).

Another issue is that sometimes, the target retirement age — which is rounded to the nearest five — is too low for today’s reality. As life expectancy continues to grow, the amount needed to live comfortably in retirement naturally grows, too. These funds don’t yet take that into consideration.

Last but not least, fees can end up being a bit more expensive on these funds, as they are actively managed. The aforementioned Vanguard funds come with reasonable expense ratios, usually around 0.17% or 0.18%. Other funds, though, can be more expensive — the USAA Target Retirement 2040 (MUTF:URFRX[14]), for instance, charges a much heavier 0.8%. That doesn’t sound like much, but a few basis points add up over 30 to 40 years.

Bottom Line

Target-date funds aren’t for everyone, but if you’re overwhelmed by the options in your 401k plan, they’re definitely for you.

Alyssa Oursler is an Assistant Editor for InvestorPlace. As of this writing, she did not hold a position in any of the aforementioned securities.

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